FLP Issues and Opportunities

Author:
Joan C. Holtz, CPA/PFS, CFP
Director
Wealth and Tax Advisory Services, Inc.
McLean, VA

Editors note: If you would like additional information about this column, please contact Ms. Holtz at joan.holtz@wealth-tax.com.

Several recent cases have challenged the formation and administration of family limited partnerships (FLPs). If generally applied, two of these, Est. of Harper, TC Memo 2002-121, and Est. of Thompson, TC Memo 2002-246, could have serious repercussions on personal financial and estate planning. Given how significant FLPs are, this column analyzes these cases failures and suggests how they may reveal some planning opportunities to CPAs.

Sec. 2036

Both cases examined the role Sec. 2036 played in FLP formation and administration. Sec. 2036 addresses transfers with retained life estates and the estate tax implications therefrom. Under Sec. 2036(a), the value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale, under which he or she retains (1) the possession or enjoyment of, or the right to the income from, the property, or (2) the rightto designate the persons who shall possess or enjoy the property or the income therefrom.

This creates problems for taxpayers who want to minimize exposure to estate taxes, but not transfer total control or enjoyment of their assets. Traditionally, FLPs have served as a technique for equalizing the tension between these two objectives.

HarperEconomic Benefits Retained

Facts. In June 1994, at age 86, the decedent formed a FLP with his son and daughter and later transferred a portfolio of investments to it. The FLPs primary purpose was the acquisition, including by purchase of, sale of, management of, holding, investing in and reinvesting in stocks (both common and preferred),bonds and other financial assets. Under the agreement, the taxpayers son was managing partner, with essentially complete authority to manage and control all business decisions. However, the agreement significantly restricted his ability to make major decisions (e.g., admission or removal of a general partner (GP)); such decisions required approval of over 50% of the FLP interests (i.e., there was a veto power).

A certificate of limited partnership (LP) was filed on the FLPs behalf with California in June 1994. Shortly thereafter, the taxpayer was hospitalized with acute cancer. In July, after his release from the hospital, he transferred 60% of the LP interests to his two children. His transfer of his investment portfolio to the FLP also commenced in July and took four months to complete. From September to November 1994, he also transferred other assets to the FLP. Two months after the final transfer, the decedent entered a hospice and died in February 1995.

After its formation, the FLP made distributions, many of which were described as return of capital to cover the taxpayers funeral needs, estate expenses and taxes. In March or April 1995, the taxpayers son engaged a CPA to prepare the FLPs books and returns, as well as the decedents income, gift and estate returns.

Analysis. The Tax Court followed Est. of Schauerhamer, TC Memo 1997-242, and Est. of Reichardt, 114 TC 144 (2002), in concluding that the FLP interests that the taxpayer gave away were includible in his estate under Sec. 2036(a), because he continued to retain enjoyment. It noted that the distribution pattern implied an understanding of such retention, even if not enforceable, because:

• Funds were commingled for over three months, without the creation of a separate bank account;

• Distributions were made disproportionately to the taxpayer, in relation to his childrens FLP interests; and

• The transfer of assets to the FLP and the gifts of FLP interests therein had testamentary characteristics.

In following Schauerhamer and Reichardt, the court emphasized two important factors, as they relate to Sec. 2036:

1. No books were established, nor separate bank account opened, until the taxpayers children hired an accountant to do so in the months following their fathers death.

2. Income from assets was distributed to the taxpayer before title was placed in the FLP and was disproportionately distributed to him after his asset transfer.

Although the court recognized that the taxpayers poor health was a reason for forming the FLP, it found that little changed during his life as to how the assets were managed or accessed. Thus, the court found the taxpayer formed the FLP only to provide for his children on his death (prior to his death, he made all decisions on creating and structuring it). Also relevant to the court were (1) the taxpayers transfer of the majority of his assets to the FLP, (2) his advanced age and ill health at the time of formation and (3) his lifetime professional experience as an attorney.

ThompsonNo Valuation Discount

Facts. A sole practitioner financial adviser, in conjunction with APS Financial Services, Inc. (licensee for the Fortress Financial Group, Inc.), encouraged the decedent to use a Fortress Plan in forming two FLPs in February or March 1993. In a letter, the promoters represented the FLPs as (1) reducing estate tax; (2) maximizing asset preservation; (3) reducing the partners income tax; and (4) facilitating family and charitable giving.

By the time the FLPs were established, the taxpayer was already in his mid-90s. He contributed nearly all of his assets to the FLPs and, as the court noted, retained only enough to support himself for less than two years. Through an agent, he withdrew from the FLPs to cover his living expenses (e.g., medical and personal) and to fund annual exclusion gifts for his children, grandchildren and great-grandchildren.

The taxpayer died in May 1995, at the age of 97, holding an 87.65% interest in one of the FLPs and a 54.12% interest in the other.

Analysis

In following Harper, Schauerhamer and Reichardt, the court noted that there was an implied agreement that the taxpayer would retain the economic benefit and enjoyment of the assets he contributed to the FLPs, despite sufficient compliance with state law to create valid entities. For example, (1) his daughter sought assurance upfront that her father could withdraw funds from the partnership to make annual family gifts and (2) the taxpayer owned so few assets directly that the GP was told he needed an infusion of funds to cover living expenses. He also retained the income from animals raised on farm property contributed to the FLP.

Although the children contributed property to the FLPs, they also retained income and gains from these assets. The effect of the transfers on the taxpayer and his children was minimal; thus, the court found the FLPs had no trade or business function and did not even represent a joint enterprise for sharing income and gain. This was also supported by a lack of any material change in the stock and bond portfolio allocation and in the investments transferred. As the portfolio was the FLPs main asset, the fact that it basically had no investment activity indicated that the entities were consistent with an estate plan, not an arms-length joint enterprise among the partners.

More evidence that the FLPs were, in reality, a testamentary alternative, came from the values reported on the estate return, which showed a 40% combined discount for minority interest and lack of marketability. Based on Harper, the Tax Court concluded that the full and adequate consideration exception under Sec. 2036 (as recognized in Est. of Harrison, TC Memo 1987-8) did not apply. It found that the assets transferred were actually recycled in the partnership.

The court noted that the taxpayers withdrawal of funds at will for his own reasons (including loans to family members) amounted to a treatment of the partnership as his personal bank account. Finally, it cited the taxpayers retention of control of the GP and LP interests as problematic.

The case also illustrates that if there is little sharing of income and gain or loss, a FLP might come into question.

FLPs in the Future

Despite the fact that the taxpayers did not prevail in Harper and Thompson, a FLP could still be an effective planning tool if its formation and administration are given proper attention. To start, if partnership documents are not properly drafted, they will not withstand scrutiny. For example, in Adams, 218 F3d 383 (2000), the drafter of the partnership agreement overlooked a provision for partnership continuity at a partners death. As a result, a district court disallowed valuation discounts for minority interest, lack of marketability, a bad mix of portfolio assets and uncertainty of assignee rights. Despite the outcome in Adams, the taxpayer could have avoided the initial challenge had the partnership documents been more comprehensive in the first place.

Post formation, FLPs need to be properly administered, with separate bank accounts and distributions in proportion to partnership interests and in accordance with the agreement. Only when the substance of a FLP cannot be easily questioned, will it be respected and valuation discounts honored during a taxpayers life or at death; see Est. of Dailey, TC Memo 2002-301. In Dailey, the IRS conceded that it was not substantially justified in maintaining a position that a FLP should be disregarded for tax purposes. As a result, it had to pay the taxpayer $42,700 in litigation costs for challenging the FLPs status.

A partner who contributes assets should not have a direct interest in the subsequent income or gain therefrom. For example, in Thompson, there was too little joint enterprise, with no sharing of income and gain or loss, which lead the Service to question the entity.

Opportunity Knocks

Many professionals are misreading cases like Thompson and Harper, in which the taxpayers' arguments failed to prevail, as the death knell for FLPs. On the contrary, this is a significant opportunity to emphasize their ability to set up FLPs properly and ensure that they are implemented correctly going forward.

While practitioners are capable in the early stages, few consider the issues that crop up beyond that and do not follow through on administration. Even when a FLP is properly drafted and implemented, if it is not correctly administered as an entity (i.e., independent of the desires of those who contributed assets to it), the IRS could have a good chance to challenge the plan. CPAs, due to their broad technical skills, can fill an important ongoing need, by (1) ensuring that an entity is being properly treated throughout the year in accordance with the initial plan, (2) assisting with partner distribution planning and portfolio asset management and (3) preparing returns.